Have Insurance Companies Forgotten the Meaning of Insurance?

By Yoni Appelbaum

Liberty Mutual was born to protect ordinary workers. Today, by funneling money from regular families into the hands of executives, it has inverted
its very reason to exist. Sadly, this case is not unique.

Flickr/takomabibelot

A hundred years ago, the factories and shop floors of the United States were home to appalling violence. Machines and tools severed digits, mangled
limbs, and, with horrifying regularity, killed their operators. Under the liability laws of the day, only one victim in fifteen received reasonable
compensation from his employers. That injustice exacerbated already tense labor relations. In Massachusetts, organized labor pressed hard to establish a new, state-sponsored mutual insurer; the Chamber of
Commerce agreed. In 1911, the legislature overhauled workers' compensation,
chartering the Massachusetts Employers Insurance Association to mitigate the hazards faced by ordinary workers.

Today, that company is known as Liberty Mutual. Over the last four years, Edmund Kelly, its CEO until last year,
cashed in
more than $200 million in compensation. That haul places him among the most highly paid executives of any corporation, even in this age of outsized
executive pay. But there is a special irony to Kelly's situation. The company he runs is the same insurer chartered by Massachusetts a century ago.
Liberty Mutual still spreads risks among its policyholders, but now it also concentrates rewards in the hands of its executives. It has, in effect,
inverted the logic of mutuality on which it was founded.

In late medieval Europe, as insurance began to assume a recognizable form, insurers would write policies on anything the traffic would bear. Contracts
were sold to mitigate the risks of trade, insuring against the deaths of trading partners, heads of state, or other figures whose dying might have
financial consequences. But nothing prevented a man from wagering on any life he chose, could he find an insurer who would accept his bet. Speculative
life insurance flourished. Contracts on the life of Admiral Byng saw premiums rise and fall with each day's testimony at his court martial, and paid off
handsomely after his execution. When George II took to the field with his army ahead of the Battle of Dettingen, insurers offered 3:1 odds on his survival. In one particularly callous instance, when
hundreds of Palatine refugees were stranded and starving on the outskirts of London, Lloyd's sold contracts on the number who would remain alive by particular dates.

It was the invention of mutual insurance that rescued the industry's reputation and enabled its explosive growth, by aligning risk with reward and
harnessing financial innovations to serve a public interest. The insurance societies and associations created by English reformers at the turn of the
eighteenth century rejected the purely transactional relationships favored by commercial insurers, with individuals placing bets that would pay off in
the event of tragedy or misfortune. In their stead, they erected contractual communities, their members pledged to mutual assistance. "Ensuring of Life
I cannot admire," wrote Daniel Defoe in 1702, endorsing
instead "a Number of People entring into a Mutual Compact to Help one another, in case any Disaster or Distress fall upon them."

Mutual insurers enabled the simultaneous pursuit of commercial and communal advantage. Holding communal mortality low kept benefits high, and profits
were distributed among the members in the form of regular dividends, making the good health of the community the surest path to profit. The premiums
created a pool of capital that could be deployed to some socially beneficial purpose. Liberty, for example, pioneered workplace safety measures, and
then distributed the resulting savings back to its members in the form of dividends. Members took these measures seriously not only for their own sake,
but also because they were the ones who stood to profit from the resulting gains. The community governed itself, electing its own directors. The
alchemy of mutuality transformed insurers from abetters of private speculation into enablers of public virtue.

The example of mutual insurers profoundly altered public expectations for the entire industry. Over the years that followed, governments enacted a
series of measures to distance insurance from gambling, and to force even commercial firms to behave more like public utilities than purely private
ventures. In 1774, Britain banned the use of insurance as a vehicle to wager on
the misfortunes of others, requiring an insurable interest to be present in any contract.
The nineteenth century brought ever tighter regulation, including oversight of premiums.

Mutual insurance flourished, bursting into full flower on our own side of the Atlantic. Hundreds of fraternal and social groups offered a wide array of benefits on the mutual model, as did mutual corporations
chartered solely to provide different varieties of insurance. To many Americans, insurance seemed a powerful tool for addressing social inequality and
reducing the risks of an unstable and uncertain world, particularly in its mutual form. So it was unsurprising that when, in 1911, Massachusetts
pioneered workers' compensation insurance, it settled on a state-subsidized mutual company as its vehicle for the reform.

The act that chartered Liberty Mutual offers a grisly testament to the terrible costs of industrial labor. It specified the benefits to be paid by the
new insurer, or by others offering similar policies. "For the loss by severance of both hands at or above the wrist," one clause detailed, "or both feet at or above the ankle, or the loss of one hand and one foot, or
the entire and irrecoverable loss of the sight of both eyes," a worker was to receive a bonus of half a week's pay, "but not more than ten dollars nor
less than four dollars," and only for the next hundred weeks. That maximum of a thousand dollar payout for a double amputee was a huge advance, but
even then, formed a sharp contrast with executive compensation. The Industrial Accident Board, set up to oversee the system, paid its chair an annual
salary of $6,500--as much in one year as the lifetime compensation for thirteen severed hands.

It is a reminder that the mutual movement never aimed to establish perfect social justice, nor to achieve precise equality of outcome. Insurance aimed
to mitigate risk, both by providing incentives to reduce it and by taking relatively small sums from each participant and aggregating them into large
payouts for the unfortunate victims. It rounded off the jagged edges of the modern economy.

By the time Kelly arrived, in 1992, Liberty Mutual had grown a long way from these early roots, with operations in every state and around the world. It
had diversified into the
auto, fire, life, and reinsurance markets. But it was struggling to stay competitive. In 1996, Liberty led a push for legislation authorizing mutuals
to place their assets into holding companies, which could in turn sell stock. It cited better access to capital markets, easier acquisitions, and
simplified accounting. Critics envisioned executives pursuing rapid growth and commensurately rising compensation. In theory, at least, mutuals were
owned by their policyholders, to whom executives were accountable. Profits were passed on to policyholders in the form of regular dividends. The hybrid
holding-company structure muddied the waters.

Liberty was the first mutual to take advantage of the new law. It converted to a mutual holding company in 2001 over the outraged howls of watchdogs,
who believed policyholders were being shorn of ownership without sufficient compensation. Over the next decade, Liberty Mutual became wildly successful
and profitable, gobbling up smaller competitors and growing into a Fortune 100 corporation. And an increasing share of its revenues were captured by
the firm's executives, instead of being booked as profits and distributed to its policyholders. Kelly, paid roughly $3 million when he pushed through
the reorganization, took home more than $50 million in salary, incentives, and deferred compensation in 2011, his final year as CEO. Liberty Mutual
leased a fleet of five corporate jets
to fly its senior managers around in style. In 2010, it paid its top nine executives
more
than the Red Sox shelled out for their starting nine.

The simplest explanation is a massive failure of corporate governance. There is ample evidence to bear that out, beginning with large salaries and
tight social ties among board members. Blaming governance, however, mistakes cause for effect.

Liberty's shifting corporate structure reflected a much deeper shift in values. When he pushed for partial demutualization, Kelly labeled the mutual
form "archaic." Only a few policyholders protested. Most confirmed Kelly's judgment with their silence--either unaware that their purchase of an
insurance policy had brought them into a community of mutual obligation or preferring to restrict themselves to a purely transactional relationship. If
Kelly walked away with the keys, it was because too few policyholders felt enough ownership to stop him.

As the mutual ideal eroded, so, too, did the conception of insurers as public utilities. Insurance giant AIG, for example, enthusiastically embraced
synthetic Collateralized Debt Obligations. After a two-century hiatus, insurance returned to the business of selling policies to people who had no
stake in the assets on which they wagered. Even worse, although the gains accrued to private individuals, the public remained on the hook for any
failures.

The same holds true of Edmund Kelly's career. As CEO, he placed big bets with other people's money. There is little question that Kelly performed well,
even superbly, during his tenure at the company. But that was also the job he was hired to do, and which he originally performed for a small fraction
of the pay (if you consider $3 million a small fraction). There is no indication that Kelly believed his primary obligations were to his policyholders,
or to society at large.

For Kelly, profits are all that matter. "It wouldn't have happened if the company hadn't done well," he said, defending his compensation, "and I'm not
going to apologize for the company doing well." It is a theory of social welfare most recently and clearly articulated by a former partner of Mitt
Romney's, whose new book
disputes
any suggestion that "risk takers, as a whole, are overpaid," arguing that if wealth were twice as concentrated, and risk more highly rewarded, society
as a whole would benefit.

Mutuals once operated by a very different moral logic, in which communal advances led to gains for every individual member, and in which individual
losses were compensated by communal aid. The community that bore the risks reaped the rewards. Today, Liberty Mutual still aggregates many small
premiums into a few large payouts, but its primary beneficiaries are now its own managers. It still rewards its policyholders for minimizing their
risks, but now dangles far more lavish rewards before its risk-taking executives.

Ted Kelly believes that moving from mutual responsibility to the pursuit of private gain has benefited everyone. It has certainly benefited him.